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Question 9 Smithfield Corporation’s stock returns have a covariance with the market of 0

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Question 9
Smithfield Corporation’s stock returns have a covariance with the market of 0.039. The standard deviation of the market returns is 0.17, and the historical market premium is 7.4%. Smithfield bonds carry a 12% coupon rate and are priced to yield an expected return of 9%. The market value of the bonds is $22 million. Smithfield stock, of which 4 million shares are outstanding, sells for $14 per share. The tax rate is 34%, and the risk-free rate is 7%.

Smithfield Corp. management must decide whether to purchase additional capital equipment. The cost of the equipment is $29.5 million. The expected after-tax cash flows from the new equipment are $9.25 million a year for five years. Purchasing the equipment will not change the risk level of Smithfield Corp. Should Smithfield purchase the equipment